At the beginning of this year, investors hoped that the stock market rally, which pushed up the Standard & Poor’s 500 Index 30% in 2013 and 173% from its March 2009 low, would continue apace. So they seized on any optimistic data and forecasts to justify their hopes.
Their enthusiasm waned in mid-January because of emerging-market woes, but soon returned, taking major indexes to all-time highs. Nevertheless, a number of warning flags are flying today. Among them:
1. High price-to-earnings ratios. These ratios aren’t at record levels, but they certainly are elevated. Yale professor Robert Shiller’s CAPE (cyclically adjusted P/E ratio), based on the last 10 years of inflation-adjusted earnings to iron out cyclical variations, was 26.5 in mid-September, 61% above the long-term average of 16.5. Stocks would need to drop by more than half to reach the long-run average (and remember that declines usually undershoot the average, just as rallies do).
Also, because this ratio has been above average for most of the last two decades, it will probably spend many future years below 16.5 — if the long-term average is still valid. It is now in the top 10% of its range, and when this occurred in the past, the real S&P 500 fell 1.4% a year over the next decade. The Shiller P/E isn’t a precise forecasting tool, but its elevated level for so many years is a warning sign.
2. Slow economic and corporate revenue growth. Real gross domestic product growth since the mid-2009 expansion began has been the slowest in the post-World War II era. I expect tepid growth to persist at about 2% annually until financial deleveraging is completed in four more years or so. With inflation running at about 1% and deflation looming, annual increases in nominal GDP of 3% or less are in the offing. In the long run, corporate profits will grow in step with nominal GDP. Furthermore, the risks to economic growth are on the downside.
Consequently, growth in corporate sales will probably continue to be minimal and pricing power almost nonexistent, resulting in further minimal rises in S&P 500 sales per share. Both consumers and businesses are forcing corporations to slash prices, and many households are again switching from national brand products to cheaper house brands.
3. Earnings depend on profit margins in the absence of meaningful sales volume and price increases. Profit margins are at an all-time high and have been on a plateau for a few years, as measured for the total economy by profits’ share of national income. Margin improvement, which is based on unsustainable cost-cutting and lower borrowing costs, isn’t as solid a foundation for profit growth as sales volume increases and pricing power are.
Costs can always be cut further, but the low-hanging fruit has been picked, as seen by the slower productivity growth since the burst in 2009 when U.S. businesses took a meat ax to costs. Furthermore, corporate interest payments can’t decline indefinitely. They have fallen along with interest rates, even though the amount of corporate debt has risen in recent years.
Since bottoming out in the fourth quarter of 2008, corporate profits as a percentage of corporate gross value-added — a proxy for corporate revenue minus inter-company sales — have leaped. They rose from 8.5% to 17.2% in the second quarter as pre-tax profits climbed by $877 billion.